What’s Ailing India’s Defense Sector?

In February 2010, Italian helicopter maker Finmeccanica won a contract for 12 helicopters from the Indian government. The $750 million contract for AgustaWestland helicopters was the biggest for the company in recent times. For Finmeccanica’s CEO Giuseppe Orsi, it meant that the company stood a good chance of getting the Indian Navy’s $250 million light helicopter deal as well.

As it turns out, the AgustaWestland deal stands cancelled. Earlier this year, Orsi was put in jail by Italian authorities in Milan for paying bribes to secure the agreement. Bruno Spagnolini, who reported to Orsi and headed the helicopter unit, was put under house arrest. Indian defense minister A. K. Antony has said the company, in the race for aerospace contracts worth $12 billion in India, might be blacklisted.

With Pakistan in the west and China in the east — both of whom India has fought wars with — India is relying on defense equipment that is more than 20 years old. That puts the country’s defense preparedness at its lowest since the 1980s. India relies on foreign players for 70% of its defense needs.

“Blacklisting major defense companies — and we have already done that with six — would mean [that] we can’t modernize our armed forces. That would be disastrous,” says a senior official in the Indian army. The main worry in Indian defense circles is that contracts take years to be signed, and then sudden controversies crop up, preventing deals from going through. Ultimately, no one wins. To date, blacklisted companies include Rheinmetall Air Defence, part of Germany’s Rheinmetall AG, Israel Military Industries and Singapore Technologies Kinetics. All have been barred from defense deals for the next decade.

“Blacklisting major defense companies — and we have already done that with six — would mean [that] we can’t modernize our armed forces.” –Senior Official in the Indian Army

In the 1980s, the government of Prime Minister Rajiv Gandhi collapsed over charges that the Swedish gun manufacturer Bofors paid bribes to supply Howitzer field guns to the Indian Army. After that, India did not purchase any guns until last year, when the government signed a deal with U.K.-based BAE systems. That means for 20 years the Indian army did not have the Howitzers it needed to combat even low-level attacks from across the border.

Dealing with Corruption

While Antony is known for being honest, he has been extremely slow at making decisions and designing better policies. A top executive at Boeing told Knowledge@Wharton, “It does take time with other governments as well, but in India the process of decision making in defense deals is extremely slow.” The companies are not going away, though — all want a share of the $100 billion that India is expected to spend on defense over the next five years.

This is not the first time that allegations of corruption have stalled a deal with no alternative in the works. In 2003, India issued an order for 197 light helicopters worth between $500 million to $600 million. Sixty helicopters were to have been purchased outright, with the remaining 137 being built under license by Hindustan Aeronautics Limited (HAL). Eurocopter’s AS550 C3 Fennec and Bell Textron’s 407 competed in the second and final round of summer trials, and as 2007 ticked toward a close, it looked like Eurocopter would emerge the winner. But then reports of corruption emerged, and the deal was derailed. To date, another deal has not been signed. That has delayed the army’s modernization efforts. “India will find it difficult to match up to China at this rate, given [the latter’s] ongoing modernization and massive capacity-building. In the next few years, there will be a big gap in deterrence,” notes Rahul Bhonsle, a defense analyst based in New Delhi.

Knowledge@Wharton High School

The problem now is two-fold: How to weed out the corruption before entering into a contract, and how to speed up decision-making once such cases have been found.

A defense ministry official says that one of the causes for delay in finalizing contracts is differences between the ministry bureaucrats and senior officers in the Indian armed forces. Unlike countries such as China or Russia, where senior defense ministry officials have prior experience working in the armed forces, Indian bureaucrats come from a separate cadre. Army officials allege that these bureaucrats have no experience and little knowledge of the industry. However, the defense ministry official says that matters are made worse by involvement of defense personnel in corrupt deals. In the helicopters deal, for example, the Central Bureau of Investigation (CBI), the federal investigative agency, named a former air force chief as one of the accused.

The slow process of investigation means that Antony is moving ahead based on what others tell him rather than on a firm footing. He recently said that Finmeccanica and Augusta might both be blacklisted. That was before the CBI submitted its report. On the other hand, Femeccanica has sent a bill to the Indian Finance Ministry for the three helicopters it had already delivered before the scandal broke, since no charges of corruption were actually proved. Under an “integrity pact” signed with AugustaWestland, India can still cancel the contract and bar the firm from bidding for any government contracts for at least five years.

“India will find it difficult to match up to China at this rate, given [the latter’s] ongoing modernization and massive capacity-building.” –Rahul Bhonsle

Sikorsky, part of United Technologies, was in the running for the helicopter deal. One its top executives, a retired air force officer, says that the defense ministry needs to be far more informed at an earlier stage about corrupt practices. In its quest to guard against corruption, “India’s defense procurement system is now extremely complex, bureaucrats [have] become risk averse and the military was not getting the equipment it needed,” Harsh Pant, an Indian defense expert at King’s College in London, said in an interview with Bloomberg.

Winds of Change

Saikat Chaudhuri, executive director of the Mack Institute for Innovation Management at Wharton, says that two things need to be done to clean up the system and introduce transparency. “First, introduce a lobbying system like in the U.S., which essentially regulates and makes transparent the basic human behaviors that lead to corruption. After all, it is not that corruption doesn’t exist per se in the West, it has just been recognized that such human tendency for power and money is innate and must be regulated as it is impossible to eliminate.”

According to Raj Kadyan, a retired army general and defense analyst, transparency in the process is critical. “What you need right now is for the process to be transparent — from the bidding process to the actual signing of the deal. Just blacklisting companies without taking other steps won’t stop corruption,” says Kadyan.

The second step, more specifically related to defense, notes Chaudhuri, is to nurture a healthy private sector to partake and eventually form a substantial part of the Indian defense industry. “This will help build the capability base and also prevent everything remaining within the government ambit, including all procurement processes. I wish to stress, however, that blind privatization or transfer of work to private firms is not the answer…. It must be accompanied by a change in system like the introduction of lobbying.”

“It is not that corruption doesn’t exist per se in the West, it has just been recognized that [it] is innate and must be regulated as it is impossible to eliminate.” –Saikat Chaudhuri

It does seem that things are changing, though slowly. The main reason is that the government-owned industries like Hindustan Aeronautics Limited (HAL) or Bharat Electricals Limited (BEL) have failed to deliver the contracts they won, and with huge cost and time overruns. The best example is the Arjun Tank, which remained in development for over a decade. Finally, the army ordered new T-90 battle tanks from Russia. A 2012 report by Boston Consulting Group said productivity of public sector defense companies in India was half the national average and lowest among all industries.

According to John Elliot, a British journalist based in New Delhi for the past 20 years, many forces have colluded to stall private players from making a mark in this space. Elliot noted in his blog: “The Indian defense establishment, which includes the defense ministry, parts of the armed forces, the public sector corporations, foreign suppliers and defense agents, have all connived in the past to block private sector development.”

Opportunity for Private Players

While the public sector firms are still trying their best to protect their turf, their shortcomings are becoming harder to ignore. Last year, for the first time in years, the Indian Army invited a private sector group to compete for a contract to build a new tactical communications system. The private sector companies involved are Larsen & Toubro, Tata Power SED and HCL. The first two have been defense suppliers in smaller capacities for years and specialize in high-precision engineering. HCL is one of the major Indian software firms. These three firms will compete against Bharat Electronics, a defense public sector corporation.

The biggest push to get more private players involved came last year when the Planning Commission called for Indian companies to be prime contractors for all major contracts. This is a big opportunity for private sector companies, which currently account for just 20% of India’s defense spending. The new procedures have a “buy and make Indian” provision — which means only local companies, including joint ventures with overseas companies, can enter bids for contracts.

Since the new procedures were announced, Mahindra & Mahindra, India’s biggest tractor maker, set up a joint venture with Israel-based Rafael Advanced Defense Systems for naval weapon equipment. Mahindra, which currently has negligible revenue from its defense business, expects sales of about $500 million in the next 10 years, vice chairman and managing director Anand Mahindra said at that time. Wipro, India’s third largest software exporter, has signed a deal with European consortium EADS to manufacture aerospace precision engineering components. Reliance Industries, the Mumbai-based operator of the world’s biggest oil refinery complex, entered into an agreement last year with France’s Dassault Aviation. Dassault is negotiating with the Indian government to sell 126 Rafale fighter aircraft, the world’s biggest such contract in the last decade.

Of course, this by itself doesn’t mean corruption will go away. As Wharton’s Chaudhuri says, lobbying must also be permitted to make the process more transparent. “A strong political leadership and will is of course desirable to develop the nation in all respects. It is tragic and inexcusable that even national security in India is compromised due to a lack thereof,” notes Chaudhuri.